Advantages of a crypto prime brokerage

Although they were originally regarded as little more than a novelty or a fleeting fad, cryptocurrencies have made some early adopters incredibly wealthy people. As such, larger and more sophisticated investors, including hedge funds, are now taking the rise of virtual currency more seriously and are looking for ways to profit from the boom in popularity.

As the world of cryptocurrency is still relatively new and the risk of volatility high, traders should tread carefully if they decide to branch out from traditional financial products.

Any investment firm, such as a hedge fund, that decides to take advantage of the growth in crypto is going to need a suitable prime broker to make their transactions possible.

Without hedge funds, prime brokers probably wouldn’t exist, and without prime brokers, hedge funds would face significant operational difficulties. But, how has this symbiotic relationship come about and why do these two entities rely so heavily on each other?

What is a prime broker?

On the surface, prime brokers offer a particular set of services to trading firms such as hedge funds and commercial banks, which are intended to optimise their operations and, in turn, generate better returns. In essence, these services handle trading, custody, and advisory matters for institutional traders and can include, but aren’t limited to, security management, capital introduction, reporting, research and regulatory advice.

Although they offer a wide range of services, a prime broker’s fundamental – and arguably its most important – role is to be the middleman between a hedge fund and two counterparties, namely commercial banks and institutional investors, like pension funds.

Hedge funds need access to these entities because banks have large cash sums that they can loan for margin purposes, and institutional investors provide a source of securities that funds can borrow for short-selling purposes.

Essentially, behind every major trade are lots of moving parts and behind every hedge fund, is a prime broker facilitating that trade by streamlining the complicated processes of making large trades.

Do we need crypto prime brokers?

Prime brokers have been providing essential services to institutional investors, particularly hedge funds, for many years - so much so that a hedge fund’s success can largely depend on their prime broker. However, because the world of digital currency is still so new, there is a significant lack of prime brokerage services for hedge funds looking to reap the benefits of crypto.

It’s likely that as more primer brokers with crypto offerings emerge, more institutional investors will want to trade virtual currencies, which in turn is likely to help the crypto market expand even further, which will likely benefit early investors.

According to a report from Bloomberg on 6 April 2021, the total market capitalisation for all cryptocurrency in the world was more than $2 trillion. This is reportedly double what it was two months prior and is the result of a surge in demand among institutional investors, a surge which has pushed cryptocurrencies to be worth more than 5% of the global trading equity ($34.8 trillion) according to Statista. However, it’s also worth noting that at the time of writing (6 July 2021), the total market cap has since sunk to $1.4 trillion, according CoinMarketCap. While this is still a significantly large figure, it does highlight the volatility of cryptocurrency, which is something investors should keep in mind.

Despite the volume, the infrastructure supporting cryptocurrencies is lacking. For example, there are thousands of exchanges but trading across them is close to impossible. A shallow solution to this would be to turn to an Order and Execution Management System (OEMS), which essentially connects traders to multiple platforms and exchanges.

However, an OEMS does little more than pull various APIs together to put the information of multiple exchanges in one place. Furthermore, implementing one would still require the trader to open and manage different accounts for every exchange they wish to access.

This is a major shortcoming compared to an actual prime brokerage and investors wouldn’t benefit from the other services one would expect of a prime broker, as mentioned previously. The cryptomarket also lacks many regulations that protect traditional investments, which is also likely to put off many large-scale investors.

The advantages of crypto prime brokers

In addition to simplifying the overall back-end processes of trading in crypto markets, crypto prime brokers help hedge funds and institutional investors by providing greater access to assets and liquidity.

Liquidity can be one of the bigger hurdles to overcome when trading crypto, especially for hedge funds, as the pool of liquidity on one exchange for a particular asset can be limited to such an extent that it isn’t enough to fill a large trade.

Among the other services you’d expect of a traditional prime broker, crypto brokers also provide advanced tools and market data that traders can use to optimise their strategies and increase their chances of success.

Finally, and perhaps most importantly, more prime brokers are starting to offer increased asset and fund protection and are regulated by recognised bodies and conduct authorities. As well as giving investors peace of mind that their capital is safe, crypto prime brokers also ensure that a hedge fund meets its legal obligations.